The new horse ruling - at last! -Oct 2007

For over 12 months the horse taxation community has been eagerly awaiting the release of the ATO's new horse ruling. The suspense had been heightened by the ATO's initial indication that it would be released as early as March of this year.

Alas, after extensive industry consultation, the ATO finally released a new draft ruling (TR 2007/D9) addressing major thoroughbred industry taxation issues on 22 August 2007. Unfortunately, due to the importance of the EI issue, this ruling has, to date, not received the attention it deserves and I can only hope that this article can finally put in the picture.

It has been 14 years since the ATO last issued a specific tax ruling relating to the thoroughbred industry (TR 93/26) and this current ruling seeks to clarify many aspects of this ruling as well as addressing many horse income tax issues that have arisen subsequent. The major catalyst for this ruling is the current ATO audit of the industry that commenced in late October 2003 and which continues to cause great angst for many serious breeders and owners within the industry.

On the whole, the ruling was successful in clarifying many of the issues in TR 93/26, but it is still has a way to go in addressing the "cutting edge" issues that effect many of the major players in this industry. I’ll be addressing all of my concerns when I formally respond to the ATO with my own submission in the next few weeks.

On a personal level, I was fortunate enough to be invited by the ATO to be part of its industry consultative panel and please forgive me for basing many of the following comments through the prism of the input I offered.

Major issues addressed

The major areas addressed by this draft ruling are:

What is a business of "racing" horses?;

What is a business of "breeding" horses?;

When "racing" activities can form part of a "breeding" or "horse training" activity;

The proper treatment of racing and breeding stock for tax purposes, i.e. is it trading stock, plant or a CGT asset?;

The deductibility of service fees; and

When racehorses can be subject to depreciation.

Amongst the areas the ruling did not comment on were foal share arrangements, "one-off" profit transactions involving horses and leasing arrangements relating to the breeding of horses and syndications generally.

ATO submissions for comment due by 10 October 2007

It must be emphasised that this is only a draft ruling and the ATO are inviting submissions to be lodged by 10 October 2007 for parties wishing to make relevant comments. Carrazzo Consulting CPAs, as a leading provider of tax services to the industry, will not only forward its own submission relating to specific tax issues, but has also been invited to participate in the general industry submission of Thoroughbred Breeders Australia (TBA) and The Australian Racing Board (ARB).

Major ruling highlights

After proper consultation with the ATO, I comment below on some of the significant specific issues addressed (or not addressed) within the ruling.

1. ATO still "hard line" on horse racing activities

Regrettably, little has changed in this area. A "stand-alone" racing activity would, in the words of the ATO, "rarely amount to the carrying on of a business".

It did restate that determining any business if a “question of fact”, thus there is still hope for major racehorse owners.

This rigid ATO position seems to have little regard to the general indicators that the AAT and courts refer to when deciding whether an activity is a tax business. It appears as though only wins by racing taxpayers at the AAT or courts will change this ATO position and our office (and the industry as a whole) must ensure that the ATO has full knowledge of these at the time this ruling is finalised.

In the ATO's view, it would be a rare case indeed where the racing of horses as a stand-alone activity would amount to the carrying on of a business. The ATO considers that one or more of the following significant non-business features would be present:

the significant element of chance meaning that whether or not a profit is made will depend very largely on considerations other than system and organisation of the taxpayer;

a very limited prospect of making a profit from the activity even if there exists a genuine intention to make one; and

the pursuit (albeit vigorous in many cases) of a hobby, recreational pursuit or pastime.

The ATO's "anti-racing" mindset is very much reflected in the somewhat predictable example provided in the ruling. The example only relates to what a "non-business"/"hobby" racing activity would typically look like – I have yet to see the ATO ever provide an example of a "stand-alone" racing business and I, for one, will urge the ATO to finally include one within its final ruling as the activity in the example looks nothing like the serious racing businesses I’m aware of. For the record, I note the ATO example below:

ATO Example 1: the racing of horses - not carrying on a business

Joe runs a successful primary production business called Grow-N-Grow Pty Ltd. Over the last few years Joe has acquired several race horses. Although he is a keen follower of horse racing, Joe does not have any particular expertise in the buying, racing or training of horses. Joe's horses are in work with a trainer who is also a good friend and who advised him on the purchase of the horses. Joe incurs expenditure on agistment, training fees and veterinary fees. Joe's horses have achieved a few minor places in local country race meetings.

Joe does not have any clear objectives in regard to his horse racing activities other than to enjoy watching them race and hopefully sometimes win. He relies on his friend to manage the training of the horses. However, there are no plans to improve the performance or profitability of his current horses. In addition, Joe has no plans to buy additional horses or sell any of his current horses to improve the profitability of his activities.

The racing of the horses by Joe does not amount to the carrying on of a business of the racing of horses. The size and scale of the activity and the lack of system or organisation directed towards the making of a profit points towards his activities being no more than those of a keen follower of horse racing.

Therefore, Joe cannot deduct the expenses relating to his horses from his business income from Grow-N-Grow Pty Ltd. The gross proceeds from the racing of the horses will also not be included in Joe's assessable income.

2. "Racing" activities can form part of "breeding" activities

Where the ATO will relax their "hard line" racing position is where the racing of horses is an "integral" part of a horse training or breeding activity. This ATO administrative position has been out for at least 6 months and it is comforting to see that it now forms its public opinion.

If the taxpayer can prove "integration" between the racing and breeding activities, e.g. fillies retained for racing to be used in future breeding, then the racing activity forms part of the breeding activity. Again, this question relies heavily on the facts of the case and a breeding business must be in existence before this test can be applied to the racing activity.

The ruling states that to be considered an integral part of the other business, the racing activities must be inherently connected with it and be consistent with the furtherance of that business activity.

Again, the ATO have again not provided a positive example of within the ruling of a person meeting this test and, again, I will urge that this is corrected within the final ruling.

3. ATO relief for "breeding" business indicators

The "6 mare" rule is dead!

As flagged in a consultation meeting I attended at the ATO in October 2006, the ruling no longer states that a tax breeder needs "at least six quality or commercial brood mares". I welcome the removal of this indicator as it very much reflects decisions of the AAT and courts in this area where many breeders have been held to be in business with less than six mares.

We also note that the ATO have not included as business indicators the need for mares to have "black-type" in pedigrees or that they should be bred to stallions with "market appeal". Throughout the audit process, this has been a strong ATO administrative position.

Thankfully, the ATO did provide an example, albeit a very extreme one, of what it considers a breeding business to look like and I note it below for your reference.

ATO Example 5: the breeding of horses - carrying on a business

Max-Win Stud breeds horses. They offer yearlings, mares and weanlings for sale to the general public. Each season they sell the majority of their draft through the major sales yards. Last year they sold 12 foals through the public sales yards and a further two in private sales before the major sales. Occasionally, they may keep a filly for future breeding purposes.

The stud does not maintain any geldings or barren mares which are inappropriate for breeding. If the stud purchases a race filly, it must have proven itself on the track before it will be used as a broodmare at the stud. Max-Win currently has 3 proven sires standing at the stud and has recently added a further unproven black type champion stallion to its roster.

There are currently 50 mares in residence at the stud. 17 of these are broodmares that belong to the stud and the rest are mares owned by individual breeders. Max-Win prides itself on their bloodlines and their 17 broodmares have produced 30 group winners. Because of this, they experience extremely strong, high value sales at the sales yards.

Max-Win Stud employs a stud manager to manage their breeding portfolio. They also employ a pedigree manager to assist with stallion selection, stallion nominations and the marketing of their bloodstock. Another manager is employed to oversee the preparation of the yearlings for sale. The stud also employs veterinary staff, stable hands, grooms, and administration staff.

Max-Win Stud is carrying on a business of the breeding of horses. This is because the general indicators in relation to the carrying on of a business are evident and the specific industry guidelines in relation to the carrying on of the breeding of horses are also evident.

Their level of activity has a significant commercial purpose. There is a purpose of profit as well as a prospect of profit from their activities because of the care they take in planning, managing and marketing the quality and number of their bloodstock. The activity is carried out in a systematic and organized manner with the regular selling of their stock to the general public. It relies more on efficient business planning, rather than chance, to be successful. The size, scale and permanency of the activity indicate a business is being carried on.

Therefore, the horses used by Max-Win Stud are not depreciating assets. They are trading stock of the business. As the horses are trading stock, any capital gain or loss Max-Win Stud makes from a CGT event that happens to a horse is disregarded. Any proceeds from the use of the horses by Max-Win Stud, including any winnings from any of their horses raced, are assessable as ordinary income. The costs of the maintenance and the development of the horses are deductible as a revenue expense. The stud will account for any changes in trading stock using their live stock accounts under Division 70.

4. Deductibility of Stallion Fees

Though a little ambiguous within the ruling, the ATO indicate that stallion fees paid pursuant to a positive pregnancy test, i.e. upon issue of a final invoice, are deductible in the year incurred.

However, the ruling also indicates that where stallion fees are prepaid, they are subject to the new special prepayment rules in terms of timing of deductibility.

This area should indicate that breeders within the former STS are the new “Small Business Entity” rules are not bound by the prepayment rules noted above and the ATO acknowledge that it is likely that the final ruling will discuss this.

5. Stock in a breeding business is treated as trading stock

This ruling makes it quite clear that stock within a breeding business, including racehorses, must be held as trading stock, e.g. fillies retained for racing and future breeding or home–bred geldings retained for the purpose of racing.

This differs to their position in the 1993 ruling where it did give the taxpayer the option to hold racehorses as depreciable plant where their major purpose is to derive prizemonies from racing.

The ATO have effectively closed off the depreciation of racehorses in a breeding business by clarifying the original 1993 ruling.

The ruling also restated the trading stock provision that horses acquired by natural increase cannot be subject to the general mare and stallion write-down provisions. It appears that there must be a degree of confusion amongst tax advisers when advising in this area.

6. Depreciation for racehorses starts from birth

The 1993 ruling stated that a racehorse can only be depreciated from two years of age.

Where a racehorse is held in a racing business, the new ruling now states that such horse can be depreciated from the time it is born. This reflects a change in the general depreciation rules since the release of the original ruling.

7. Hobby racehorses still considered "Personal Use Assets"

The ATO have not overturned their 1990 ruling which stated that racehorses (or interests therein) held by hobbyists are designated as “Personal Use Assets” under the Capital Gains Tax rules.

Assets in this category are tax exempt if acquired for $10,000 or less. The industry believes that this threshold is too low and should be increased to a level commensurate with the increase in average yearling prices over the past ten years.

You are welcome to contact me if you wish me to clarify or expand upon any of the matters raised in this article.

Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information's applicability to their particular circumstances with an accountant specialising in this area.

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